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Page 1 of 22 – CAS, E: Reinsurance Accounting Principles
E.
Reinsurance Accounting Principles
1. Describe reinsurance accounting terminology and practice, and evaluate considerations such as risk
transfer testing and commutations.
a. Identification and evaluation of insurance and financing components of the contracts
Blanchard and Klann, Basic Reinsurance Accounting - Selected Topics
b. Determination whether the contract qualifies for insurance accounting treatment or deposit
accounting treatment (i.e., passes risk transfer), and understand impact on financial
statements
SSAP62R_PropertyAndCasualtyReinsurance.pdf
Freihaut and Vendetti, Common Pitfalls and Practical Considerations n Risk Transfer
Analysis
FASB, ASC 944-020-15
c. Commutations—definition, motivations of parties, and accounting and tax treatment
Steeneck, Commutation of Claims, a CAS Study Note
Page 2 of 22 – CAS, E: Reinsurance Accounting Principles
BLANCHARD, "BASIC REINSURANCE ACCOUNTING - SELECTED TOPICS"
* Question: List the Six Principal Functions of Reinsurance (Harrison)
Answer:
•
Increase Large Line Capacity
•
Provide Catastrophe Protection
•
Stabilize Loss Experience
•
Provide Surplus Relief
•
Facilitate Withdrawal from a Market Segment
•
Provide Underwriting Guidance
* Question: Increase Large Line Capacity Example –
1. Give an example of how reinsurance can be used for this function.
2. What is the impact on Surplus, Loss Reserves, Unearned Premiums, Leverage Ratios and the Income
Statement
Answer:
1. Use surplus share (a type of proportional reinsurance) treaty to cede premiums and losses for higher valued
homes so that insurer is able to write in this market segment
2.
Surplus
-Little direct impact
-Given additional premium, reserves, and rein collectability risk, may need to hold more surplus
-Could decide to reduce volume to retain same level of surplus relative to risk
Loss Reserves –
Both gross and net loss reserves increase, partly due to increased premium volume and partly due to
the nature of new business being pursued, with slower development on larger claims.
Unearned Premiums
- increase, but remain the same in proportion to premium
Leverage Ratios (WP/Surplus)
Net leverage ratios increase slightly because of the change in business model. Gross leverage ratios
begin to differ materially from the net leverage ratios, and reinsurance leverage (ceded
balances/surplus) becomes important due to the purchase of reinsurance.
Income statement –
Little changed on a net basis, but over time the riskier book and changing cost of reinsurance may
introduce greater volatility.
Page 3 of 22 – CAS, E: Reinsurance Accounting Principles
* Question: Provide Catastrophe Protection
1. Give an example of how reinsurance can be used for this function.
2. What is the impact on Surplus, Loss Reserves, Unearned Premiums, Leverage Ratios and the Income
Statement
Answer:
1. Company buys catastrophe treaty to reduce its potential loss from a catastrophic event. Pays 5% of gross
premium that pays for losses from a single event in excess of 10% of GWP. Mandatory reinstatement
charge of 2% of GWP if cat treaty attachment is reached.
2.
Surplus
- Decreases surplus if no cat occurs due to cost of reinsurance, but can reduce risk of significant drops
in surplus if large cats occur. Note that reinstatement premium is included in cost or reins.
Loss Reserves
- Net reserves not impacted unless covered cat occurs
- If cat, gross reserves can significantly increase for short period of time
- If size of cat losses within reinsurance limit, net reserves will return to normal levels sooner than
gross reserves
➞ Retained portion of cat is generally paid first before ceded portion of cat, thus the treaty
doesn’t kick in until the attachment point is reached.
Unearned Premiums
- Little to no change b/c cat reins premium is usually small
Leverage Ratios
- If no cat, biggest impact may be from reduced surplus in denominator
- If cat occurs, gross and net ratios significantly impacted without reinsurance
- With reinsurance, only gross ratios significantly impacted if cat occurs (GWP/Surplus)
- Ceded reinsurance leverage (ceded balances / surplus) can be significantly impacted in the period
after major cat, prior to runoff of resulting cat loss reserves
➞ Ceded balances include ceded loss reserves, ceded unearned prems, and
reinsurance recoverables from amounts billed but not yet collected
Income Statement
- Investment income is reduced
➞ don’t forget to consider investment income loss when purchasing reinsurance. In example,
all premium was assumed to be ceded at the beginning of the year.
- Underwriting income is substantially protected (assuming CAT stays within the maximum limit of the
CAT reinsurance program.
Page 4 of 22 – CAS, E: Reinsurance Accounting Principles
* Question: Stabilize Loss Experience Example * 1. Give an example of how reinsurance can be used for this function.
2. What is the impact on Surplus, Loss Reserves, Unearned Premiums, Leverage Ratios and the Income
Statement
Answer:
* 1. Capital provider demands or management desire to limit year to year fluctuations in loss experience.
Insurer buys an aggregate excess of loss treaty for the entire book on January 1st, for 10% of gross premium
that returns 90% of losses above a loss ratio of 100%. The reinsurance premium is payable at the start of the
year. (Note that this assumption results in zero ceded unearned at December 31st. Ceded unearned would be
greater than zero if the ceded reinsurance policy term had not yet expired.)
2.
Surplus
- Expected value of surplus is lower with rein, but less period-to-period variation due to EXPECTED net
cost of reinsurance.
- Year to year impact varies based on gross losses
Loss Reserves
- Stabilizing net loss experience generally translates into stabilizing net loss reserves
➞ May also make it easier to estimate
- Gross reserves reflect the full volatility of year-to-year results
Unearned Premiums
- Reduced on a net basis due to the purchase of reinsurance, unless (as in our example) the
reinsurance is purchased with a single effective date and the accounting date being used is the
reinsurance expiration date.?????
Leverage Ratios
- Ratios on a net basis should be more stable but slightly higher (due to reduced surplus), assuming
there is a positive net cost of the reinsurance.
Income Statement
- U/W results expected to be lower over due to net cost of reinsurance that reduces surplus
- investment income would be lower.
- Year to year u/w results should be more stable
Page 5 of 22 – CAS, E: Reinsurance Accounting Principles
* Question: Provide Surplus Relief * 1. Give an example of how reinsurance can be used for this function.
2. What is the impact on Surplus, Loss Reserves, Unearned Premiums, Leverage Ratios and the Income
Statement
Answer:
Ceding Premium = ceding commission ratio * ceded premium (increase to assets)
* 1. Use quota share reinsurance to reduce net leverage ratios - 50% quota share with ceding commission of
20% (consistent with the gross expense ratio).
Leverage ratio is WP/surplus. Smaller ratio is better.
2.
Surplus
- Liabilities decrease because half of the losses and unearned premium are ceded, but assets decrease
because of the cost of the reinsurance. The net effect in our example is a small decline in surplus, since
the ceded business was profitable. This quota share reinsurance would only increase surplus if the
business was being written at a loss.
Loss Reserves
- Net reserves are a fixed percentage of gross reserves
Unearned Premiums
- Net reserves are a fixed percentage of gross reserves
Leverage Ratios
- Net leverage ratios are significantly improved, except ceded rein leverage ratio (ceded
balances/surplus) increased
- Insurer solvency becomes more reliant on reinsurers' solvency
- Leverage ratio change not exactly in line with % ceded due to lower surplus. While premiums and loss
reserves drop in half, surplus does not stay constant. Hence, a cession of more than 50% would be
required to obtain a 50% reduction in net premium and reserve ratios to surplus.
Income Statement
- Underwriting income is cut by QS ceded% (50% in this example)
- Investment income is significantly reduced
Page 6 of 22 – CAS, E: Reinsurance Accounting Principles
* Question: Facilitate Withdrawal from a Market Segment
* 1. Give an example of how reinsurance can be used for this function.
2. What is the impact on Surplus, Loss Reserves, Unearned Premiums, Leverage Ratios and the Income
Statement.
Answer:
* 1. Insurer buys prospective reinsurance on January 1st to cede 100% of the remaining
unearned premium, and all losses occurring after the beginning of the year. A ceding
commission is included to cover the commission portion of the unearned premium, which the
insurer paid during the previous year.
2.
Surplus
- Liabilities decline to zero as losses and unearned premium are ceded, but assets decrease because of
the cost of the reinsurance. The net effect, once again, is a small decline in surplus, since the ceded
business was profitable. However surplus will be less volatile if there are unexpectedly large or small
losses during the runoff year.
Loss Reserves
- Gross reserves unchanged but net reserves to zero
Unearned Premiums
- Gross reserves disappear over the year as the business runs off. Net reserves disappear immediately
when the unearned premium is ceded.
Leverage Ratios
- Net leverage ratios are zero, therefore only insurance risk is reinsurance collectability
- Frees surplus to support existing or new business
Income Statement
- Underwriting results reflect a profit because the ceding commission offsets expenses which were
paid the previous year. This profit is slightly smaller than if the business had not been ceded. However
the risk in the results is now greatly reduced (and limited to the risk in reinsurance collectability and in
investment results).
* Question: Provide Underwriting Guidance
* 1. Give an example of how reinsurance can be used for this function.
* 2. Explain why this would be used by an insurer
3. What is the impact on Surplus and income
Answer:
* 1. Example closest to Increase Large Line Capacity example, buying surplus share reinsurance. The insurer
heavily reinsures its writings in the new market.
* 2. May be used when entering new market or must be in one to support another of its markets
- Insurer doesn't feel it has expertise in market
3. Impact on surplus and income dependent on profitability and volume (after reinsurance cessions)
Page 7 of 22 – CAS, E: Reinsurance Accounting Principles
of new business
Page 8 of 22 – CAS, E: Reinsurance Accounting Principles
Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
What are the objectives of this paper?
Answer:
Risk transfer analysis has many nuances that can trip up an actuary testing a contract. This paper discusses
several of these pitfalls and provides direction on how to address them. This paper also addresses several
outstanding risk transfer concerns that have no easy answers.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
What (risk transfer) requirements must be met for a contract to demonstrate risk transfer in order to receive
reinsurance accounting treatment under Generally Accepted Accounting Principles (GAAP).and SAP?
Challenges related to these requirements?
Answer:
1. The reinsurer assumes significant insurance risk under the reinsured portion of the underlying insurance
agreement.
2. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.
Challenges:
The terms “significant insurance risk,” “reasonably possible” and “significant loss” are not defined in either
accounting standard, so there are challenges to appropriately interpret and apply the accounting standards to
each reinsurance transaction
NOTE: American definition of significant insurance risk: possibility of significant variation in timing and amount
of cash flows under the contract.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
What is the exemption from the above risk transfer requirements and reason for it with example?
Answer:
Exemption from Risk Transfer – “Substantially All”
Exempt contracts where the reinsurer assumes substantially all of the insurance risk relating to the reinsured
portions of the underlying insurance contracts
⇒ Allows insurers to obtain qualifying reinsurance on profitable books of business
⇒ E.g., straight quota share
Page 9 of 22 – CAS, E: Reinsurance Accounting Principles
X Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
In the Reinsurance Attestation Supplement (RAS), what are the CEO and CFO required to confirm?
Reasons for this?
Answer:
1. There are no separate written or oral agreements between the reporting entity and assuming reinsurer
2. Every reinsurance contract is documented for which risk transfer is not reasonably self-evident and details
the transactions economic intent
3. Reporting entity complies with all requirements set forth in SSAP 62
4. Appropriate controls are in place to monitor the use of reinsurance
Reasons for this: abuses of the past several years in the use of finite reinsurance contracts have highlighted the
need to document and quantify risk transfer
X Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question: In the Reinsurance Attestation Supplement (RAS), what is the purpose of adding the clause: “for
which risk transfer is not reasonably self-evident” and what is the problem with this clause?
Answer:
It was meant to reduce the need to rigorously test every reinsurance contract for risk transfer.
The problem is that very little guidance was offered on what “reasonably self-evident” encompasses.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question: The CAS Working Party paper went a step further than the above guidelines and provided a list of
specific contract categories where risk transfer is reasonably self-evident based on meeting a 1% Expected
Reinsurer Deficit (ERD) threshold. Why do the authors feel that it can be dangerous to attempt to codify this
terminology with explicit definitions?
Answer:
Applying specific parameters on the terminology can lead to unintended results because there are always
exceptions to the rules.
Risk transfer testing is a principle-based exercise and not just a “plug and chug” methodological exercise.
Page 10 of 22 – CAS, E: Reinsurance Accounting Principles
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
What method of Measuring Risk Method for determining if there is risk transfer has gained acceptance and
overcomes some shortcomings of the “10-10” rule?
Describe the method.
Answer:
Expected Reinsurer Deficit (ERD)
Probability of a NPV underwriting loss for the reinsurer times the NPV of the average severity of the
underwriting loss
Generally, transfer of risk is shown if ERD > 1% {Consistent with 10-10 rule (10% loss x 10% chance)
Summary: Prob of an u/w loss * NPV of avg Sev > 1% = Freq * Severity > 1%
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
List the common pitfalls of risk transfer analysis
Answer:
- Profit Commissions (from loss sensitive reinsurance contracts) (pmt by reinsurer to ceding co)
- Reinsurer expenses
- Interest Rates and Discount Factors
- Premiums
- Evaluation Date
- Commutations and Timing of Payments
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
Should profit commissions be considered in risk transfer analysis and why?
Answer:
No, because when determining if risk transfer is present, the accounting standards clearly state that the
presence of risk transfer requires a “reasonable chance of a significant loss” to the reinsurer. Therefore, the
results of the ceding company should not be considered in a risk transfer analysis.
Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
Describe how profit commissions can affect risk transfer analysis.
Answer:
1. Any addition of a profit commission clearly increases the amount of future expected payments by the
reinsurer to the ceding company and may result in a higher premium for the contract.
2. Carryforward provisions, which allow profits or losses from prior years to be included in the results of future
years, may impact a loss position for the reinsurer and needs to be included in the model.
Page 11 of 22 – CAS, E: Reinsurance Accounting Principles
Note: TIA answer – The reinsurer may charge a higher premium to account for the fact that profit commissions
may need to be paid.
Page 12 of 22 – CAS, E: Reinsurance Accounting Principles
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
Should reinsurer expenses be considered in risk transfer analysis and why?
Answer:
No, because only cash flows between the ceding company and the reinsurer should be considered in a risk
transfer analysis.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
A. What are common pitfalls when choosing an interest rate to be used for discounting in Risk Transfer
Analysis?
B. Why can’t a yield curve be used to discount cash flows in a risk transfer analysis?
Answer:
A.
1. Not using a constant interest rate for all scenarios. The analysis should only include insurance risk,
not investment, currency or credit risk.
2. Same interest rate should apply to all cash flows, including premiums and losses.
B. Would produce different interest rates when timing of cash flows differs. This goes against accntg
standards.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question: Explain the requirements for a discount rate when performing risk transfer analysis.
Answer:
1. SSAP 62 requires constant interest rate across all simulated scenarios, usually the risk free rate
2. SSAP 62 requires a reasonable and appropriate interest rate
3. AAA recommends using the risk-free rate with duration = that of reinsurer’s net cash flows. Select an
interest rate based on the years of maturity and yield curve rates from U.S. Treasury rates curve.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question: When performing risk transfer analysis, when premiums of a reinsurance contract are dependent
upon future events, what are possible premiums that can be used and what are the problems with each one
that is not proper and which one is proper?
Answer:
Initial Deposit premium: intuitive and simple choice but does not account for future payments from the ceding
company to the reinsurer and therefore could be easily manipulated under scenario analysis.
Expected Premium: Potential over detection of risk - when premium is dependent on loss experience, then
under the high reinsurer loss scenario, the high loss is divided by the average expected premium, yielding a
loss percentage that isn’t even possible. (In the iterations with the highest losses, the premium should be
higher as well).
Actual Premium is the proper choice. Actual premiums should be developed along with the losses for each
scenario and that each scenario should have a corresponding percent of reinsurer loss developed. From these
simulated results, percentiles and values such as ERD can be calculated.
Page 13 of 22 – CAS, E: Reinsurance Accounting Principles
Actual premium is also the proper choice when there is no possibility of future reinsurance premiums. (Actual
premium is based on the losses simulated.)
Page 14 of 22 – CAS, E: Reinsurance Accounting Principles
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question: What evaluation date is used for risk transfer analysis and why and when can it change?
Answer:
The inception date of the contract is used because the contract shouldn’t change materially because of a
renewal. In the case of an amendment that makes a material change to the amount of risk being transferred,
the amendment date should be treated as the inception date of the contract and the contract should be
reviewed again for risk transfer.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question: How does a commutation clause figure into the risk transfer analysis calculation?
Answer:
According to SSAP 62, any reinsurance contracts that have prescribed payment patterns do not meet the risk
transfer requirements. Contracts with commutation clauses may still meet risk transfer requirements, but to
the extent they affect the cash flows between the ceding company and reinsurer, they must be modeled.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question: List and briefly describe practical considerations in risk transfer analysis?
Answer:
- Parameter Selection: interest rate, payment pattern and loss distributions used for projecting cash flows
- Interest Rate Selection: risk free rate is lowest possible choice or a “floor”
- Payment Pattern: variability in payment pattern can especially affect the tail of a distribution, which is often
the portion we are the most interested in for determining a risk transfer.
- Loss Distributions: Having an adequate comfort level with the tail results produced by the selected
distribution is crucial.
- Parameter Risk: The majority of the parameter risk in discounting comes from two key inputs, the payment
pattern and the interest rate. Payment pattern relates to timing risk and interest rate does not contribute any
risk.
- Use of Pricing Assumptions: One potential resource, if available, for selecting parameters for small or
immature books of business is the reinsurance pricing assumptions.
- Commutation Clauses: any mandatory fees to delay a required commutation should be included when
determining if risk transfer is present
Page 15 of 22 – CAS, E: Reinsurance Accounting Principles
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
What are different (from risk free rate) discount rate possibilities for risk transfer analysis and describe them
Answer:
Rate lower than risk-free rate: would lead to higher present value losses and could result in over-detecting risk
transfer
Rate based on reinsurer rate of investment return (higher than risk-free rate): may create a scenario where a
contract may be found to exhibit risk transfer for a reinsurer with poor investment strategy, but may be found
not to transfer risk for a reinsurer with superior investment strategies.
Constant yield curve (a yield curve that doesn’t change): would match timing of cash flows to different rates.
Would also result in higher discount rate for losses than premiums b/c premiums are paid much sooner. Since
a constant interest rate is required, this is not allowed. The reason for this requirement is to avoid interest
rate risk.
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
Explain the concept that pricing and risk transfer analysis have different intents and what are the
consequences?
Answer:
1. For pricing, it is conservative to expect large losses. For risk transfer analysis, it is conservative to
expect lower losses and more variability. Thus, pricing overdetects risk.
2. Since a risk load is included in pricing, but not in risk transfer analysis, the risk load should be
considered when deriving the variance of the loss distribution.
3. Loss models for pricing are often focused on the projections of all possible results.However, risk
transfer testing is focused on the tail.
Page 16 of 22 – CAS, E: Reinsurance Accounting Principles
* Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
What are the advantages and disadvantage of using reinsurance pricing assumptions for conducting a risk
transfer analysis?
Answer:
Advantages:
1. Assuming that the contract is priced appropriately, it can indicate reasonable assumptions about expected
losses and payment patterns, as well as an appropriate risk load.
2. Pricing assumptions, especially the risk load, also provide a view about how risky the market views an
account.
Disadvantages:
1. the market really should not be impacting the simulation for the purpose of risk transfer testing. Therefore,
the actual data used to determine the pricing assumption is therefore preferable to the actual pricing
assumptions themselves.
2. Actuary needs to account for the pricing risk load, which may be included in the expected losses, properly.
Freihaut, D.; and Vendetti, P., “Common Pitfalls and Practical Considerations in Risk Transfer Analysis,”
Question:
What are main conclusions of this paper?
Answer:
1. Risk transfer analysis, and more specifically ERD, is a tool to aid actuaries in the risk transfer analysis
decision.
2. Risk transfer testing is a principle-based exercise and the existence of risk transfer is entirely based upon
there being a “reasonable chance of a significant loss” to the reinsurer.
Page 17 of 22 – CAS, E: Reinsurance Accounting Principles
* FASB944, “Financial Guarantee Insurance Contracts”
Question:
What occurs when a reinsurance contract does not provide for indemnification of the insured or the ceding
entity by the issuer or reinsurer against loss or liability?
Answer:
The premium paid less the amount of the premium to be retained by the reinsurer shall be accounted for as a
deposit by the insured or the ceding entity.
* FASB944, “Financial Guarantee Insurance Contracts”
Question:
When does indemnification of a ceding company exist?
Answer:
When there is:
a. Significant insurance risk. The reinsurer assumes significant insurance risk under the reinsured portions of
the underlying insurance contracts. Implicit in this condition is the requirement that both the amount and
timing of the reinsurer's payments depend on and directly vary with the amount and timing of claims settled
under the reinsured contracts. (uncertainty in both amounts and timing)
AND
b. Significant loss. It is reasonably possible that the reinsurer may realize a significant loss from the
transaction.
* FASB944, “Financial Guarantee Insurance Contracts”
Question:
How to you differentiate btw a short duration and long duration insurance contract?
What are the criteria for a short duration contract?
Answer:
Insurance contracts shall be classified as short duration contracts or long-duration contracts depending on
whether the contracts are expected to remain in force for an extended period.
Criteria for short duration:
1. Provides protection for a fixed period of short duration
2. The contract allows the insurer to cancel or change the provisions at the end of any contract period such as
adjusting the amount of premiums charged or coverage provided.
Page 18 of 22 – CAS, E: Reinsurance Accounting Principles
FASB944, “Financial Guarantee Insurance Contracts”
Question:
Describe how different reinsurance instruments can be combined and give examples.
Answer:
Reinsurance contracts may include both prospective & retroactive provisions.
Examples:
1. The same contract may cover losses from policies written both in prior years (claims made policies), and in
future years (occurrence policies).
2. Reinsurance may be acquired after the primary policy has been written, but before the end of the coverage
period, and made effective as of the beginning of the contract period.
* FASB944, “Financial Guarantee Insurance Contracts”
Question:
How does the ceding entity evaluate whether it is reasonably possible for a reinsurer to realize a significant
loss from the transaction?
Answer:
The evaluation shall be based on the present value of all cash flows between the ceding and assuming entities
under reasonably possible outcomes, without regard to how the individual cash flows are characterized.
The same interest rate shall be used to compute the present value of cash flows for each reasonably possible
outcome tested. To be reasonable and appropriate, that rate shall reflect both of the following:
a. The expected timing of payments to the reinsurer
b. The duration over which those cash flows are expected to be invested by the reinsurer.
Note: Commutation should not be part of the calculation unless commutation is expected.
* FASB944, “Financial Guarantee Insurance Contracts”
Question:
If the reinsurer is not exposed to the reasonable possibility of significant loss, under what condition would the
ceding entity be considered indemnified against loss or liability relating to insurance risk?
How would that condition be met?
Answer:
The condition is such that if substantially all of the insurance risk relating to the reinsured portions of the
underlying insurance contracts has been assumed by the reinsurer.
That condition is met only if insignificant insurance risk is retained by the ceding entity on the reinsured
portions of the underlying insurance contracts. This is assessed by comparing both of the following:
a. The net cash flows of the reinsurer under the reinsurance contract
Page 19 of 22 – CAS, E: Reinsurance Accounting Principles
b. The net cash flows of the ceding entity on the reinsured portions of the underlying insurance
contracts.
Page 20 of 22 – CAS, E: Reinsurance Accounting Principles
FASB944, “Financial Guarantee Insurance Contracts”
Question:
Explain the business perspective of the above exemption.
Answer:
This exemption in the preceding paragraph is for contracts that reinsure either an individual risk or an
underlying book of business that is inherently profitable.
The reinsurer's economic position shall be virtually equivalent to having written the relevant portions of the
reinsured contracts directly.
Page 21 of 22 – CAS, E: Reinsurance Accounting Principles
STEENECK, "COMMUTATION OF CLAIMS"
* Question: Define commutation
Answer:
• Process where the future value of an unpaid claim(s) and associated expenses is 'current valued,' taking
into account financial and non-financial aspects, to accelerate payment and close the case(s)
* Question: Explain the parties in a commutation
Answer:
- Seller - entity that has claims and expense obligation (reinsurer) – selling liabilities (pays cash)
- Buyer - entity receiving obligation (ceding company) – buys liabilities (receives cash)
- This transaction is the reverse of a premium payment
* Question: List the attractions of a Commutation from the buyer’s viewpoint
Answer:
a. Accelerated settlement of the obligation
b. Improvement in current "wealth" using entity's perception of value of cash over non-cash assets
c. Cash flow for reinvestment or liquidity to deploy for other purposes
d. Certain immediate amount is substituted for an uncertain future amount
e. Possible admin cost saving associated with monitoring and collection efforts
f. Creating a marginal underwriting loss and federal income tax marginal adjustment
* Question: List the attractions of a Commutation from the seller’s viewpoint
Answer:
a. Accelerated settlement, often times ending relationship with buyer
b. Improvement in perceived "wealth" when considering financial and non-financial aspects
c. Limited attractive cash flow alternatives
d. A certain result, not subject to future events such as contract remediation or retroactive legislation or
judicial results
e. LAE administrative expense savings
f. Creating a marginal underwriting gain with a probable adverse current tax consequence
* Question: Describe the main difference between the Canadian situation and the US situation when
calculating the ambivalence point of a commutation of a reinsurance treaty.
Answer:
- Canadian situation, tax considerations increased the seller's AP
- US situation, tax considerations decreased the seller's AP
Page 22 of 22 – CAS, E: Reinsurance Accounting Principles
* Question: Explain how seller will handle loss and expense reserving for a commutation. Best way to adjust
data. Also, same questions for buyer of liabilities.
Answer:
- Paid loss value increases by amount paid to ceding insurer
- Case reserve decreases by the liability sold (usually decreased to 0)
- New Incurred value = Old Incurred Value + Change in Paid + change in case reserve
- If price paid > case reserve, then there will be positive development in gross incurred and the reverse is also
true.
- The best way to adjust data is to isolate all the data subject to transaction and remove it from the historic
database.
- The reverse of all the above is true for the buyer of the liabilities.
* Question: Explain the balance sheet and income statement accounting for a commutation from seller’s
point of view. Buyer’s point of view.
Answer:
1. Seller reduces assets by cash considerations – balance sheet
2. Seller releases liabilities by amount of reserves held – balance sheet
3. Premium or commission accruals may be impacted by the change in apparent loss experience – balance
sheet?
4. Any tax consequence is also booked
5. Impact on buyer - generally reversed
6. Income statement will show net impact in the “Loss” and “Tax” provision lines.